Savers who have significant portions of their pensions allocated to UK stocks may find themselves losing tens of thousands of pounds by retirement, based on analysis of the last five years of investment returns.

The UK government is encouraging investments in domestic firms and the chancellor, Rachel Reeves, is anticipated to introduce pension reforms aimed at shifting billions from savers into UK businesses. However, an analysis by the Sunday Times reveals potential negative consequences for many pensioners.

The analysis examined the default funds of 18 major workplace pension providers, which collectively manage approximately £497.6 billion for about 17.2 million individuals.

The investment strategy of a default fund typically adapts depending on how far a saver is from retirement; younger individuals often see a greater proportion of their investments in equities. Evaluating performance data provided by Corporate Adviser, we found that for a saver 30 years away from retirement, annualized returns from 2018 to 2023 varied from 5.1% to 12.9%.

National Pension Trust, with an investment of just 3.9% in UK stocks, achieved the highest returns at 12.9%. Conversely, nine funds with less than 5.3% in UK stocks outperformed those more heavily invested in domestic stocks, showing average annualized returns of 9.75% over five years.

Funds with holdings exceeding 5.2% in UK stocks yielded an average annual return of 7.08%. The Lewis Workplace Pension Trust, which allocates 30% to UK equities while diversifying the rest internationally, reported impressive annualized returns of 9.39% over the same period.

According to Renny Biggins of The Investing and Saving Alliance, “The possibility of mandatory investment in UK stocks cannot be dismissed. However, we oppose this necessity, as investment choices should prioritize the best interests of members. Given the current underperformance of UK stocks relative to global markets, it raises the question: why would you choose to invest more domestically?”

The Cost of Supporting UK Stocks

Performance is critical for individuals enrolled in defined contribution pension plans, where retirement income is directly tied to savings and investment performance.

In contrast, defined benefit pension participants usually enjoy guaranteed retirement income based on their salary.

For instance, consider a worker starting with a salary of £25,000 who is automatically enrolled in a defined contribution pension and is contributing 8% of their salary (including employer contributions). If this fund achieves an average growth of 7.08%—typical for those heavily weighted in UK stocks—after 30 years, the retirement pot would amount to approximately £122,652, based on estimates by PensionBee. This projection factors in a fee of 0.7%, inflation of 2.5%, and a 1% annual increase in wages.

However, if their investments matched the less UK-centric funds’ average growth of 9.75%, their retirement savings could swell to £194,216—an additional £71,564.

Becky O’Connor from PensionBee remarked, “Recent years have highlighted that globally-focused funds tend to produce the best returns, rather than those concentrating on UK markets.”

Comparatively, the UK FTSE 100 index has risen by 11.8% in the last five years. In contrast, the MSCI All-Country World Index—which tracks 2,687 companies across 47 nations—has surged by 63.6%, while the US S&P 500 saw an even more significant increase of 85.2%.

Tom Stevenson from Fidelity International noted, “The growth of the US market has largely been fueled by technology companies and, more recently, advancements in artificial intelligence. A significant factor in the UK market’s lackluster performance is its structure; the FTSE 100 lacks sufficient growth-oriented stocks that have dominated the market over the last decade.”

Stevenson further commented on the potential for continued tech-related growth, especially with changing political climates possibly favoring deregulation and economic incentives.

Nevertheless, the Treasury has suggested that policies promoting increased pension investments in UK infrastructure and private equity could lead to savers being approximately £11,000 better off at retirement.

Reviving the UK Investment Landscape

Reeves aims to spur more investment in the UK, leveraging the considerable influence of pension funds.

Statistics show that shareholding in UK stocks by pension funds has plummeted from 32.4% in 1992 to just 1.6% by 2022. Research from the think tank New Financial indicates that average allocations to UK equities from pension funds decreased from 53% in 1997 to a mere 4.4% in 2022, making the UK’s exposure among the lowest of major economies.

This drop could reflect pension funds’ alignment with global investment trends, given that the UK constitutes only 3.2% of the MSCI All-Country World Index, compared to the US’s 65% and Japan’s 4.9%.

Additional factors contribute to this trend, including the substantial closures of private sector final salary schemes that shift assets from equities to safer bonds to ensure stable returns for retirees.

Tax reforms have created a further disincentive for pension funds to invest in UK stocks. In 1997, the elimination of tax credits on dividends for pension funds severely impacted their appeal, which in turn hampered UK stock investments.

Stevenson stated, “The lasting effects over the next quarter-century have far exceeded the £5 billion a year benefit for the Treasury, as the lost opportunity for compound growth from reinvested dividends accumulated to around £250 billion over 20 years. This reform diminished a key incentive for domestic investment.”

Biggins contended that reinstating tax incentives would be more beneficial than mandating UK investments. Australia’s tax credit system, still intact, has allowed their pension funds to maintain an average of 24% of assets in domestic stocks, as highlighted by New Financial.

Moreover, a 0.5% stamp duty fee is incurred whenever shares are purchased, adding to the financial burden of investing.

William Wright from the think tank remarked, “The shift away from UK equities has fostered a cycle of diminishing demand, leading to depressed valuations and further declines in interest.” He added that adjustments in pension fund strategies could significantly influence the recovery of the UK equity market.

Future Considerations

Biggins expressed concerns that the government’s emphasis on domestic investments may compel pensions to explore riskier options like private equity and infrastructure.

Typically, default workplace pension funds invest in low-cost trackers mimicking stock indices such as the FTSE 100. Changing these strategies could introduce greater risk, and there are doubts about whether pension funds possess the requisite knowledge to engage in these complex markets successfully.

With nearly 30% of new businesses launched in the last five years failing, investments in this domain carry inherent risks and necessitate specialized comprehension.

Increased investment complexity may lead to higher fees. Although the cap on default pension fund fees stands at 0.75%, the industry argues for adjustments due to the complexity and costs associated with private equity.

Since the onset of the 2023-24 tax year, pension scheme trustees may exclude certain performance-based fees from this cap, potentially driving higher costs for savers while seeking to back UK’s innovative businesses.

Nonetheless, any significant changes to how pension funds invest may take years to materialize.

Last year, 11 of the largest UK defined contribution pension providers indicated that it might take until 2030 for them to allocate 5% of their default funds to unlisted stocks following an agreement with the Treasury.

Empowering Savers

For savers eager to influence their investment decisions, opting for alternative funds beyond the default option can be advantageous. A diverse range of investment choices is typically available to align with individual risk appetites, especially for younger savers who can afford to withstand market volatility.